12 August 2024: Valuing a Business: 4 Mistakes to Avoid
Most business owners have an idea what they think their business is worth. But in our nearly 25 years in the business of brokering businesses, we’ve learned that it’s the rare owner whose estimated value is even remotely close to what the market suggests it is.
Small business owners arrive at their valuation numbers using a variety of different methods. – usually some “multiple” of some financial metric. But we usually find that the “multiple” they use was one suggested by their barber or auto mechanic and the financial metric is almost always incorrect. When valuing a business, seeking professional insight – from someone who values businesses on a regular basis – is highly recommended.
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We’ve discussed business valuations – their importance and their complexity – repeatedly over the years and there’s no reason to repeat all of that here. (For in-depth discussions, go to the main blog page of our website and type “valuations” or “value” or “valuing” in the search bar at the upper right.)
This post is focused more on mistakes of omission that many business owners make when preparing to sell their business. Aside from the first one, it’s about how value is impacted by non-financial or non-numerical aspects of the business.
There are more than just the ones mentioned here but, out of respect for your time, we try to keep these posts to under 1,500 words.
1) Not Knowing Its Value
Like most everyone else, business owners have a good idea what their house is worth, what their car or boat is worth, what their 401k or pension plan is worth and even what their collection of classic hubcaps or Barbie dolls is worth; but it’s surprising how few have given any thought to what their business – what is most likely their most valuable asset – is worth.
In fact, it’s exceedingly common for business owners to wait until they’re ready to sell before considering what their business is worth. Worse, many wait until they have an offer.
Understanding the value of your business and how it changes over time ought to be a key metric in measuring your company’s performance.
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If you want your business to be worth, say, $5 Million when you retire in ten years, the first question ought to be: What is it worth now? And the second question ought to be: What makes it worth that; what is driving that value?
Answering these questions will help in identifying what can be done to increase the business’ value – and possibly reach the owner’s valuation target earlier than planned or scoring a higher valuation at the end of the 10-year period.
2) Not “Knowing” Your Buyer
Every business has a buyer or type of buyer. But not every buyer is right for every business.
And though every transaction requires a ready, willing and able buyer, the smoothest transactions and the deals that are most beneficial to the seller are those that are done with the right type of buyer.
Knowing who your buyer is likely to be means knowing who to market to. Knowing who to market to is knowing how and where to market, bringing efficiencies to the selling process and eliminating a lot of wasted time answering questions from people who are unlikely to ever buy.
A willing buyer is not necessarily an able buyer. Even if someone sees the value in your business, unless they have access to the required amount of capital, you’re nowhere. That means banks or other funding sources must see the value in your business as well. It’s therefore critical to understand how willing banks are to loan money to buyers in your particular industry, and on what terms.
That statement alone should be a very persuasive argument for having your business professionally valued. Few lenders have any idea how to value a business and, lenders being risk-averse by nature, none will be willing to lend without a professional valuation – unless, of course, the buyer has sufficient liquid assets to eliminate the lender’s risk in which case the lender is unlikely to care what the business is worth or even if it fails.
If you don’t understand who can buy your business and how they’re going to pay for it, it’s unlikely you’ll reach a reasonable valuation.
3) The Business Owner
Business owners tend to forget just how much they’ve come to know about their area of expertise over time, and often feel that others – buyers – have much, if not all, of the knowledge needed to run the business. This type of thinking can be downright dangerous when valuing a small business.
A business owner that ignores their own expertise, knowledge, connections and experience will either overvalue other factors in explaining the value and success of their business or fail to understand that without their unique contributions the business is likely to be perceived as less valuable – by the buyer and/or the lender. The problem with this approach is that the value of the owner him- or herself is not being sold with the business. Downplaying their own importance will cause an owner to overestimate the value of their business.
Landscaping businesses offer an illustrative example. An owner of a successful landscaping business may not consider themselves all that important to the business because they have dozens of employees along with large investments in vehicles and equipment. The landscaping business does not have educational barriers for admission nor does it require lengthy training or unusual talent. Intuitively, this may push many toward the conclusion that the business “runs itself,” and therefore derives its value separate from its owner.
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Courses! Courses! Courses!
Many of you have asked if our Flagship Course, “Learn How to Value and SUCCESSFULLY Sell Businesses“, could be made available on a module-by-module basis. We’re happy to report that this is now possible.
We’ve broken our Flagship into six separate modules (or module groups) to give you all the flexibility you need to learn only what you want to learn – and we’ve moved them all over to the new Brokers Academy in The Brokers Roundtable℠ . The Flagship is still available but the modules are now available individually.
You don’t need to be a Member of The Brokers Roundtable℠ to access any of these courses but if you are, you’ll receive a 20% discount on the cost of any course you enroll in. If you’re not yet a member of The Brokers Roundtable℠, you can learn more – and get access to all the talent and resources – here.
But the value of the business is still extremely owner-dependent – on the owner’s skill, experience, and accumulated knowledge – and a new owner – the buyer – comes in without any of that. Such a buyer will recognize this flaw and adjust the value he or she gives the business accordingly; which is to say, down.
4) Jim Cramer
Jim Cramer is a TV stock market prognosticator of some renown. His schtick is, in a phrase, flamboyant exuberance.
He yells, screams, rants and moves around the screen with tie loosened and shirtsleeves rolled up as if he was actually doing some physical work. But he – and the dozens like him – spout numbers, arcane phrases and in-the-know terms that many people don’t really understand. One of these terms is “P/E ratio”.
The P/E ratio of a company’s value refers to what the price per publicly-traded share of a company’s stock is relative to that company’s earnings-per-share. For example, as I write this, Microsoft’s P/E is $34.41; that is, the market is valuing MSFT at $34.41 per $1.00 in earnings. Put simply, buyers of MSFT are paying a multiple of 34.41 for MSFT.
While MSFT might seem like an extreme example, it isn’t. Apple’s P/E is 32.92. Capital One’s is 12.68. ExxonMobile‘s is 14.24. Chip maker Nvidia‘s is 61.3. The problem is that many business owners, if they pay attention to these people, eventually come to believe that their business would reasonably have a similar P/E. The owner of a $10 million manufacturer of white-label IT components and peripherals might look at the bottom line on the P&L or the taxable income number on last year’s tax return and multiply that by Apple’s 32.92; and arrive at a number that, even cut in half to reflect that fact that Apple might be somewhat more well-known than Moe’s Magical Modems, is ridiculously over-priced.
That example also illustrates a glaring flaw in the approach business owners use to estimate the value of their business. Not only is the multiple generally applied completely meaningless but the number to which it’s applied – the P&L bottom line or the taxable income – is also very likely to be grossly inaccurate.
The Bottom Line
We’ve posted often on valuing businesses, mostly about aspects of how it’s done but also about mistakes people make if they’ve no training on how to do it. Those previous posts were generally discussions of math – the tangible aspects of business valuation.
But there are many aspects – tangible and intangible – that must be considered. In our courses on valuing businesses, we urge business owners, business brokers and real estate agents to try to imagine how a buyer will approach the valuation. We remind our clients, as well, that the price expectation must be justifiable or there’ll be precious few buyers.
I’d like to hear from you. What topics would you like me to cover? How can we tailor these posts to be more useful to you and your business. Let me know in the comments box, below, or email me at
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If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.
Joe
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The author is the founder, in 2001, of Worldwide Business Brokers and holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) of which there are fewer than 600 in the world. He can be reached at
jo*@Wo*******************.com